Whenever I say something like this, I usually end up regretting it because making definitive statements is never safe — about anything.
The paradox is that such statements make for compelling short articles, and especially compelling headlines, which, in turn, are conducive to reader satisfaction. Going the safer route, which entails making long, qualified statements with carefully placed caveats, is exhausting for me on some days, and exhausting for readers on every day.
With that in mind, allow me to say, definitively, that the purported “mystery” of 2022’s “strange” vol regime was never a mystery and remains wholly unmysterious.
I don’t know what compels the mainstream financial media to dwell on this point as much as they do, but as far as vol dynamics go, it’s extraordinarily simple. If you don’t “have it on,” so to speak, your beta to equities is low and you’re more overweight cash than you’ve ever been, you don’t need to hedge. Or at least not as much.
When you contextualize that by way of the epochal macro and policy regime shifts that characterized 2022, there’s no mystery. This is very straightforward, but it’s also very important, which is why it continues to come up.
“I’ve been blabbering about [this] in every damn note because it’s been such a wild regime change story from the past decade,” Nomura’s Charlie McElligott said Tuesday, before explaining the situation, again, for the still inquisitive.
“As opposed to the QE era, where the Fed incentivized ‘investors’ to be leveraged Long financial assets, necessitating large hedging of downside risks, which meant steep Skew, the recent QT / global central bank ‘financial conditions tightening era’ of the past year has meant the opposite: 0%ile Skew / Put Skew on no demand for hedges, since you don’t have much (if any) underlying exposure on,” he wrote. The figures (below) are poignant.
This explains 100%ile Call Skew. You don’t have to worry about your left tail because your longs aren’t extended, but you do have to worry about rallies, for the same reason.
As Charlie put it, you have to cover “your right tail crash-up risk” because you’re “horrified to miss these impulsive +10% Nasdaq / +7% S&P rally-type moves” like those seen in and around last week’s CPI report.
As one Goldman flow trader put it late last week, regarding funds, “There is no FOMO from clients, but there is FOMU (fear of materially underperforming) into year-end if we actually do rally.” “Positioning is under-exposed to a rally from here and the pain trade is higher,” he added.
Of course, this all feeds on itself. “With the spot rally / short-cover melt-up / chase, that 100%ile Call Skew in index options [from] under-positioned funds hedging for this very sort of right tail move has gone ITM and picked up impossible $Delta,” McElligott went on to write, noting that prior to Monday’s small pullback, the cumulative net $Delta add across US equities index and ETF options was $608 billion over the week, a 100%ile event in the bank’s data history.
Sounds healthy to me.